How Japan’s New Economy Could Affect Your Investments

The prospects for the Japanese economy continue to be encouraging. The country’s decade of deflation and flat growth is fading into the history books.

Japan may face higher interest rates as yields remain relatively high with the benchmark Japanese 10-year government bond yielding about 1.62%. Higher yields suggest a near-term increase in interest rates by the Bank of Japan and the beginning of a new trend of higher interest rates, which have also occurred in many other countries. Many pundits believe the Japanese economy has gained enough footing for the central bank to raise interest rates again. Recent household spending data in Japan was much stronger than expected, up 1.3% in February versus the 0.6% estimate.

By all indications, the Bank of Japan will increase interest rates, but, at the same time, it wants to make sure that it doesn’t put a damper on the economy and Japan’s renewed enthusiasm. The central bank increased its target for overnight loan rates to 0.5% in late February, the second time it has increased this rate in a year. The consensus is calling for a potential rate hike to materialize in the third quarter.

Previously, the central bank had ended its super-easy monetary policy that had pegged interest rates at zero. Now it’s hinting at increasing rates.

The Nikkei 225 continues to trade just off its five-year high on a rising trendline. The rise in the index reflects the steady improvement in corporate Japan.

The reality is that regardless of when Japanese interest rates rise, the trend is up. Higher Japanese rates may also hurt the flow of investment capital into higher-yielding U.S. bonds, which has been a favored destination for Japanese capital during the past decade. The demand for U.S. bonds helped support the U.S. dollar, but, should Japanese interest rates rise to a point where they are attractive, we could very well see a decline in the flow of capital into U.S. bonds.

This shift could pressure the U.S. dollar as Japanese investors would need to buy fewer U.S. dollars to use to buy U.S. bonds. The aftermath could put some pressure on the U.S. to increase interest rates on bonds to help attract investors, and this would inevitably impact stocks. This is just something to think about.